What Is Holding Gold Back?

Post Script to Feb. 11: GoldCorp Warrants didn't get sold as planned. The bid dropped down by over $1 the following day so I decided to hold for now. I was able to sell the balance of my Iamgold shares at a record high so my cash position increased. Meanwhile the value of my remaining precious metals related holdings has declined by 5%.

WHY DON'T GOLD RELATED STOCKS SURGE UP?

Most gold bugs, I expect (including myself), believe that the rationale for the ascendancy of gold to the preeminent position for global money seems obvious and compelling. Well if that's the case, why are gold mining stocks generally well below their 52 week highs and why isn't bullion breaking new highs?

Bill Carrigan, a longstanding and reputable independent technical analyst, wrote this Saturday (Valentines Day), Feb. 14, p. , Toronto Star, B7 as follows: "... Gold stocks continue to frustrate by refusing to keep pace with the recovery in bullion prices. As of mid-week there were only three new 52-week highs in the entire gold stock complex The broader AMEX Goldbugs Index (HUI) trading at 317 is still 39% below the its 52-week high of 519.6." He goes on to state that, "In order to confirm that the current run up in Gold is real, and not a sucker rally, we need the gold stocks to confirm the move by breaking to new 52-week highs. This means we need the TSX Gold Index to pop by at least 25% over the 400 level over the next few weeks."

I would like to offer my hypothesis for the slowness of gold to fulfill its potential. I think that given the unprecedented financial turmoil experienced since last Sept., we should all be surprised that gold has held up as well as it has. In the current incomprehensible, mixed up mess of a financial world, where investors are hoarding the $US as a 'safe haven currency', spot gold bullion @ US$940/oz is within 7.6% of its 17th of March, 2008 closing high of US$1,011. I would argue that it has not yet moved higher because the world still needs $US currency to wind down over-leveraged situations, the depth of these unstable positions is unfortunately beyond my capability to measure and I'm not sure if data is available in any case. The Saudi prince who must pay a casino debt; the investment fund manager who must collapse a long position to satisfy redemptions, and the Russian oligarch who must sell gold holdings to help offset falling revenues from other business sources all share in their needs to raise cash but their intentions escape measure until they act. So lets just recognize as fact that there are undoubtedly quite a few active & potentially large non-producer vendors of gold and that they will be tempted to sell into gold's current strength in order to satisfy deleveraging and cash flow liquidity requirements.

Thus my vision for the ascendancy of gold is that we must first work thru seller's inventories before gold really takes off. Or better stated, gold bullion sales will churn until vendors no longer feel it is in their interest to sell. Unfortunately this hypothesis complicates our ability to predict a date at which gold will really take off. I suspect that date is several months away from today and that the price of gold bouillon will continue to cause concern and frustration for us goldbug investors until one day, the urgent $US currency needs for deleveraging will have been largely satisfied and vendors will believe that it is no longer in their financial interest to sell.

What indicators are available that might reassure us golgdbugs that we are not simply being lured into another sucker gold rally? At this point we know that the recent 5 month gold stock upwards "trend is our friend" and the related upward move in bullion pricing is being watched around the globe.... but whether this trend will continue and accelerate is the question. Given that we have the above noted vendors we need to ask who is buying their holdings? I believe that one powerful measurable source of data for this question is the quantity of gold bullion being purchased by investment funds, gold trusts, etc. I was truly amazed to discover that just one of these funds, SPDR Gold Trust, has been purchasing, on behalf of its investors:
109.02 tonnes in 2006
174.64 tonnes in 2007
152.00 tonnes in 2008
205.63 tonnes ytd Feb 13, 2009.

Assuming that this story is repeated in other gold funds/trusts, net bullion demand by these funds is incredibly strong and implies that average investors, who are quite often wrong, are really getting involved in the global gold play.

Global Gold Production: To put this into perspective, the world's largest producer (est.8%-10% of total global mining of est. 2,500-2,700 tonnes/year), Barrick Gold, produces 20.2 tonnes/month (650,000 troy oz/month ... there are 32,150.746 troy ounces/ton).

Gold Demand Analysis is Complex: It is estimated that jewelry producers have used some 2,400- 2,700 tonnes/year of gold (ref. to National Geographic, Jan. 2009, p.43 and http://www.galmarley.com/FAQs_pages/production_consumption_faqs.htm). That's right, more gold has been used for jewelry production alone than is mined in a year. From a rational perspective, I would think that the demand for jewelry would decline but I'm the first to admit that I could be way off base. Human beings are emotional and in view of our harsh economic times and related financial crisis realities, buyers may well demand more gold jewelry now than ever before in response to a decline in purchasing power of currency. Unfortunately I think that this largest segment of gold demand is probably quite difficult to measure on a regular (monthly/weekly) basis and I would welcome any inputs on this topic from other readers. Other uses such as electronics & other industrial & dentistry (combined demand est. for 2007 = 460 tonnes) could also be in decline, but retail investment demand which includes bar hoarding, official coins, medals, special coins and exchange traded funds/trusts (combined est. for 2007 = 700 tonnes) is very likely increasing sharply.

Demand Measurement Conclusion: So as far as I can determine, we only have one element of gold's complex demand equation that we can measure semi-accurately on a regular weekly or monthly basis and that is the inventory of gold held in gold trusts and exchange traded funds. So lets keep our eyes on this and remember that individual investors in these trusts can dispose of gold interests just as fast (or faster) than the accumulated them.

Price Surge Conclusion: From the above discussion we can see that it is unrealistic to expect the complex gold market to respond instantly to news regarding one or two factors in the demand-supply equation. Furthermore we should anticipate large fluctuations and volatility in this market. That is why I plan to sell significant portions of many of my holdings after they have appreciated substantially. I don't think that this gold rally is much different from other booming investment sectors that I've come across in the past. Bullion is unlikely headed for $2,000+/oz on a straight line basis. I'm convinced investors will have several outstanding opportunities to participate in a long term gold rally yet there will also be many instances where we will wish that we stayed invested.

However I think that we should expect both bullion and gold mining stocks to trend upwards, if they don't, we need to rethink our entire hypothesis. I'm not sure we should establish deadlines but if gold fund/trust demand continues at present levels, I would expect to see a solid move upwards, 25% to 50% for most of our holdings, as they return to or exceed previous 52wk highs. My guess is that this will happen in the next month or two but with all the noise of the global financial crisis in the background, it is really difficult to call. I also think that as bullion surpasses $1,011/oz, non-producing sellers of gold will become increasingly reluctant to off load their inventories as hoarding & greed will more likely improve ROI prospects.

Things will go wrong...for example there will very likely be news that implies surprising strength in currency and various elements of the gold supply & demand equation will come into question. One can imagine headlines as follows: Dentists no longer using gold; "Peak Gold" theory in doubt; Russia Nationalizes Gold Production; Tax Bill proposed to disallow interest costs on money borrowed for gold related investments; etc. Secondly investors like myself, and the technical analyst Bill Carrigan quoted above, who invest in gold producing companies should not expect mining stocks to necessairly match increases in the price of bullion. We have seen this decoupling phenomenon before when we were oil and gas investors ... oil, the underlying commodity price, went from $80/bl to $140/bl (up 75%) but our O & G income trust or integrated oil company typically only increased by 35% to 40%. Why? because investors didn't think that $140/bl oil was sustainable. Turns out they were right. So let's anticipate a substantial lag in the appreciation of gold mining shares compared to bullion prices. In fact, we need to determine if we wouldn't be wiser to simply switch investment strategy into a bullion play.

This lag will happen unless we are presented with a series of events that unquestionably convinces all of us that astronomical gold prices are here to stay for a long, long time. In light of the current global financial crisis I think that this outcome is possible. Furthermore we should build this possibility into our investment strategy but I'm not sure we want it to happen. If it does, we might make a few bucks but, we will not be able to look forward to a very satisfying, enjoyable old age for ourselves or a promising future for our children.